Oracle's Wide Moat Can Survive in the Cloud

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Investors in Oracle have been anxiously waiting to see how the firm is going to handle the transition to the cloud. I'm here with Matt Coffina, he is the editor of our StockInvestor newsletter, for an update.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me.

Glaser: So, obviously, Oracle has a large installed base in software, but the big question hovering over the firm has been will they be able to transition to that software-as-a-service model or transition into the cloud? What kind of progress are they making there?

Coffina: Sure. So, this is definitely the major question hanging over Oracle. The company is maybe a little slow to react to the threat of cloud computing. You've seen companies like Salesforce.com, Workday come out with cloud-first solutions in some of Oracle software verticals and they've been able to win business and in some cases, take clients directly from Oracle.

Oracle has really now refocused its entire efforts around the cloud and updating all of its major software platforms for cloud computing. This is an effort that took about a decade for them really to get their software in shape. But we think that now they are a point where they can technologically match the offerings from companies like Salesforce and Workday, while at the same time being ahead of some competitors like SAP in other software verticals that are even more core to their business, so things like database, middleware, enterprise resource planning software.

So, a bit of a rocky ride the last couple of years as Oracle has prepared for this cloud transition or tried to catch up with their competitors. But we think that going forward they are going to have a very good chance to retain the vast majority of their customers and we think that their customers, because they face such high switching costs, are for the most part going to prefer to stick with Oracle and transition to the cloud with Oracle.

Glaser: Yeah, it was going to be my next question about their competitive advantage. Do you see their economic moat really continuing to be so strong in the cloud versus their historical levels?

Coffina: Sure. We've always thought that Oracle had one of the widest moats in the enterprise software industry and it's probably being put to its greatest test ever right now and that moat is really based on customer switching costs. So you have companies using Oracle software, again especially the database, the middleware and some of the more fundamental, more complex applications, things like enterprise resource planning. And those switching costs are because these software programs hold the data, customer data, business partner data, that's really essential to any modern corporation. The data is really the crown jewels for most of these companies. So, they are very hesitant to switch to a competing platform where they risk disruption to their fundamental business processes.

The same thing with something like ERP; it's integrated through so many different aspects of your business; it's integrated into all sorts of other applications. And to try to switch that out for a competing software is very risky and it's very expensive to do that. So, most customers would rather stick with Oracle as long as they can present a technologically relevant solution. It's a little bit of a different story when you're dealing with new customers. A new customer is going to probably put everything in the cloud. A new company that's being started up today is going to put everything in the cloud. They are going to really prioritize minimizing costs and they are going to be much more open to working with a company like Workday. But for a company that's been an Oracle customer for maybe decades in some cases, they have all sorts of applications written around Oracle's programming languages, lots and lots of applications tying into their database, it's just going to be too risky and too expensive to try to switch vendors. If Oracle can present a technologically relevant solution, we think those switching costs are going to really keep their clients with them.

Glaser: We're seeing the signs that they have finally started to get the cloud. They are getting traction there. Does that mean that the shares have kind of caught up with that reality? What do valuations look like today?

Coffina: Sure. So, the company hasn't really shown any overall earnings growth for the last couple of years. Part of that's been foreign exchange headwinds, but an even bigger part is this cloud transition. So, as you move customers to the cloud, you end up giving up your upfront on-premise license revenue and that's a lot of revenue that they're realizing upfront versus the cloud business you're spreading that revenue out over multiple years through a subscription. So, the first year cloud revenue is going to be significantly lower than an on-premise license. But the good news is that in subsequent years that on-premise license was just going to generate support revenue; that might only be 20% of the upfront license revenue versus the cloud subscription revenue is completely recurring. If you want to continue to use Oracle's cloud software, you have to keep paying them every single year the same amount or get even more likely a rising amount because the company is going to have some pricing power because of the switching costs.

So, in the early stages--and this is a trend we've seen pay out with other software companies like Adobe or Autodesk--in those cases, it played out much more quickly and it was a much more dramatic shift toward the cloud. Oracle because their software is more complex, it takes much longer to make these transitions and so this has really dragged out for a number of years. But we think they are at sort of a key inflection point now where accelerating cloud revenue growth is going to start to more than offset lost license revenue, at the same time cloud margins are expanding very quickly at this point as they are absorbing a lot of those upfront costs already, but now the recurring revenue really kicking in and that's helping the margins. And we think they are right around this inflection point now where the growth in the cloud is going to more than offset the declines in the legacy business and this is going to enable a return to earnings-per-share growth. So, I'm optimistic that we're right around that inflection point right now and once we see more robust earnings growth, I think that the stock can perform well.

Glaser: Do you think that the shares are attractive at today's levels?

Coffina: Well, the stock has come up a little bit. We actually just recently made a trade in Oracle. We previously owned the stock in our Hare portfolio and I moved it over to our Tortoise portfolio. So the Hare's our more aggressive portfolio. The Tortoise is our more conservative, slower-growing portfolio. I think given the maturation of the business and the competitive threats that Oracle does face, I think the growth profile is going to be much more Tortoise-like going forward than Hare-like. But that said, I think the valuation is still very reasonable and for a more conservative investor looking for a more steady-Eddie kind of technology business, I think that Oracle remains one of the better opportunities out there.

Glaser: OK. Great. Matt, thanks for sharing your thoughts today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.